THE SEC IMPOSES ANOTHER ROUND OF SAFEGUARDS FOR INVESTORS

On December 16, 2009, the SEC adopted rules to enhance the custody controls for investment advisers in an effort to provide greater protections for investors in situations where there is a heightened potential for fraud. Investors are particularly susceptible to fraud when they turn over control of their assets to their investment advisers.

Investment advisers generally do not maintain custody of their clients’ assets, but instead such assets are maintained by a third-party custodian. This arrangement helps minimize the potential for misappropriation of the clients' assets. However, the more control an adviser has over its clients' assets, the greater the risk of misuse of those assets.

One of the main situations in which there is an inherent potential for misuse of client assets is when an adviser serves as the custodian of its clients’ assets. This type of arrangement does not allow for an independent, third-party custodian to serve as a safeguard against any potentially self-serving actions by the adviser. To enhance investor protection, the new rules adopted by the SEC provide that advisers in this situation will be subject to a “surprise exam” at least once every year to verify client assets. In addition, these advisers will have to undergo an annual review of the controls they have in place regarding custody. SEC Chairman Mary L. Shapiro is confident in the potential effect of the new rules, stating her belief that “the new rules will encourage the use of fully independent custodians,” thus minimizing the potential for fraud on investors.

Another situation in which the potential for fraud is heightened is when an investment adviser does not maintain physical control over its clients’ assets, but still has authority over the assets (i.e., when an adviser serves as trustee to a trust, has a power of attorney, or has the ability to write checks on a client’s account). Under this arrangement, the only way to supervise the adviser is for the clients to closely monitor their accounts and try to identify any abnormalities. As a safeguard for investors in this situation, the new rules will again provide for an annual surprise exam to verify client assets. As Chairman Shapiro acknowledged, “[w]hen an adviser takes on the privilege and responsibility of having unfettered access to a client’s money…there is…the need to have an auditor’s ‘second set of eyes’ confirm that those assets exist.”

Recognizing that the new rules may be particularly burdensome for small investment advisory firms, the SEC is conducting a one-year study to discern the impact of the surprise exams on small firms to determine whether modifications to the new rules will be necessary.